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Unformatted text preview: Chapter 12 Cash Flow Estimation and Risk Analysis Answers to End-of-Chapter Questions 12-1 Only cash can be spent or reinvested, and since accounting profits do not represent cash, they are of less fundamental importance than cash flows for investment analysis. Recall that in the stock valuation chapter we focused on dividends, which represent cash flows, rather than on earnings per share. 12-2 Capital budgeting analysis should only include those cash flows that will be affected by the decision. Sunk costs are unrecoverable and cannot be changed, so they have no bearing on the capital budgeting decision. Opportunity costs represent the cash flows the firm gives up by investing in this project rather than its next best alternative, and externalities are the cash flows (both positive and negative) to other projects that result from the firm taking on this project. These cash flows occur only because the firm took on the capital budgeting project; therefore, they must be included in the analysis. 12-3 When a firm takes on a new capital budgeting project, it typically must increase its investment in receivables and inventories, over and above the increase in payables and accruals, thus increasing its net working capital (NWC). Since this increase must be financed, it is included as an outflow in Year 0 of the analysis. At the end of the projects life, inventories are depleted and receivables are collected. Thus, there is a decrease in NWC, which is treated as an inflow in the final year of the projects life. 12-4 The costs associated with financing are reflected in the weighted average cost of capital. To include interest expense in the capital budgeting analysis would double count the cost of debt financing. 12-5 Daily cash flows would be theoretically best, but they would be costly to estimate and probably no more accurate than annual estimates because we simply cannot forecast accurately at a daily level. Therefore, in most cases we simply assume that all cash flows occur at the end of the year. However, for some projects it might be useful to assume that cash flows occur at mid-year, or even quarterly or monthly. There is no clear upward or downward bias on NPV since both revenues and costs are being recognized at the end of the year. Unless revenues and costs are distributed radically different throughout the year, there should be no bias....
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